Ten Years On: Are Derivatives Markets Safer?

Regulations put in place after the global financial crisis—precipitated by the fall of Lehman Brothers in September 2008—aimed to reduce credit and market risk and take the burden for propping up struggling institutions away from the tax payer. This was largely successful, but in the process, many believe CCPs have replaced banks as the new institutions that are “too big to fail.” Lynn Strongin Dodds explores the CCP monopoly effect in the IRS, FX and CDS markets, the steps being taken to mitigate the risks it poses to the markets, and discusses how custodial banks could be next.

A ten-year anniversary is always one to be marked, and the decade that has passed since Lehman is no different. There has been much soul searching over the past few weeks, but the lingering question today is whether the system is more secure. Banks are seen to be safer institutions thanks to a raft of regulation, but ironically perhaps the too big to fail mantle has shifted to the central counterparties (CCP), which now play much bigger roles in the post financial crisis world.

Industry participants in Europe, for example, have expressed concern over the scenario of a few clearing members suffering large losses due to margining failures. This could deplete a CCP’s liquid assets and back-up lines, which in turn would have a ripple effect on unfunded liquidity arrangements and the remaining clearing members. Moreover, collateral requirements of CCPs could spike in times of crisis, which would have a negative impact on banks and other financial system players.

The “interdependencies” between the houses and their members was highlighted in a recent paper by the Financial Stability Board (FSB), the Committee on Payments and Market Infrastructures (CPMI), the International Organisation of Securities Commissions (IOSCO), and the Basel Committee on Banking Supervision (BCBS). It noted that a small number of entities tend to dominate the provision of critical services between them and other entities, which “suggests that a failure at one of these central elements of a CCP network would likely have significant consequences for the rest of the network.”

The monopoly effect is particularly felt in the interest rate swap (IRS) and foreign exchange (FX) markets, where LCH’s SwapClear rules the roost, as well as in the credit derivatives domain, which is dominated by the Intercontinental Exchange (ICE). This is borne out by the first half-year report card from Clarus Financial Technology, which shows that central clearing as regulation intended is increasing with US dollar and euro IRS, US and European credit derivatives and non-deliverable forwards, all posting significant hikes in volumes compared to the same period last year.

In addition, the research confirms that the biggest CCPs in each product have cemented their positions. London’s LCH SwapClear accounted for an 87% chunk of the $19.8 trillion US dollar swaps market (with CME comprising the rest), and 99% of the €12.7 trillion euro IRS market in the second quarter of 2018.

This is despite reports that Deutsche Borse’s Eurex is making inroads with its new incentive scheme launched in January to entice more participants to use its services. The initiative enables banks, asset managers and market makers to have a share of the clearing profits; and the five most active users have secured seats on the German-based CCP’s supervisory board, a position that gives them a voice in how clearing operates. Analysts believe Brexit could be a catalyst for clearing to move to Frankfurt, but say it is difficult to predict when a meaningful shift to Germany from London will occur.

As for the US credit default swaps (CDS) market, ICE Clear Credit maintained its lead in Q2 with a towering 98% share of the $2 trillion volumes generated. ICE Clear Credit also played a leading role in Europe accounting for 60% of the €1.6 trillion-euro CDS market, followed by ICE Clear Europe with 30% and LCH CDSClear with 10%.

This is a far cry from pre-Lehman, when banks and their counterparties tended to bypass CCPs to privately negotiate contracts and create their own bespoke derivatives. It was considered a less expensive option than using the CCP, but the fall of Lehman and teetering of the seemingly sleepy insurer AIG led US and European regulators to push clearinghouses front and centre as a safety valve to reduce counterparty risk in the derivatives market specifically, and systemic risk more generally.

While Lehman’s hefty $35 trillion derivatives portfolio comprising about 5% of the global derivatives market grabbed the headlines, the real shock was discovering that AIG’s financial product division had written CDS on over $500 billion in assets, the most troublesome being the $78 billion portion on multi-sector collateralised debt obligations (CDOs)—a security backed by debt payments from residential and commercial mortgages and home equity loans. When the dust settled, it had lost $30 billion on these bets, resulting in a massive $182 billion government bailout.

“The Lehman crisis acted as a wake-up call to derivative market participants,” says Christian Lee, a partner at consulting firm Catalyst, who in 2008 was working as a risk manager at LCH. “The G20 summit and other regulator meetings were determined to prevent a systematic situation from happening again and looked to de-risk the market through mechanisms such as clearing, increased transparency and increased capital requirements of banks.”

As with all regulations, there are unintended consequences and, in this case, Lee points to concentration risk among a handful of CCPs. “The bigger players have grown because they have the capital and oversight required, as well as economies of scale,” he adds. “However, regional clearinghouses such as Japan Securities Clearing Corp and Hong Kong Exchanges and Clearing are co-existing in their domestic markets.”

Mechanisms such as a default waterfall have been put in place in the event that a counterparty runs into difficulty. These range from clients having to post margin in the form of collateral equivalent to a percentage value of the contract, to raising that margin when there are signs of trouble. CCPs also operate funds that can be tapped if a client defaults, plus they can call on banks—usually the larger ones—for top-ups to the fund.

In May, the European Commission proposed a new recovery and resolution framework that would require CCPs to include scenarios based on a clearing member default, as well as other non-default situations, such as fraud or cyberattacks. It also calls for greater international cooperation, better European coordination, a stronger analytical foundation of CCP resolution planning and giving central banks greater oversight.

The proposals received mixed reviews, with clearing members arguing that venues should put more of their own and not clearing member’s capital at risk. Moreover, the European Association of Clearing Houses (EACH), expressed its unhappiness over handing over greater supervisory oversight to central banks. In a recent note, it said the move could allow central banks an effective veto over decisions related to prudential matters for CCPs, as well as issues related to monetary policy. It adds that this is likely to lead to imbalances compared to the role of the national competent authorities, the European Securities and Markets Authority (ESMA) and the CCP supervisory colleges and will complicate decision-making.

The trade body reiterated that CCPs having to obtain approvals from four different supervisory bodies, following four separate decision-making processes, is “likely to lead to increased divergence and inability to make required changes in a responsive manner to market and risk developments.”

The resolution and recovery process is a work in progress, according to Lee. “Regulators and participants are still grappling with putting the safeguards in place but there is still much more work to be done. The market is in a stronger place with clearing, but we have basically shifted the risks from one group of participants to another and it would be frightening if a CCP failed.”

The importance of working out a solution was underscored by the recent debacle at Nasdaq, when a Norwegian power market trader racked up a €114 million loss in the power markets. He not only exceeded the collateral he had set aside to cover such an event but was unable to meet margin requirements due to price movements. This resulted in clearing members having to stump up a minimum of €30,000 to a default fund that is activated when collateral proves insufficient. The exchange also set aside a further €19 million (Skr 200 million) to bolster its market stabilisation.

Who owns the risk?

“One of the problems is the clearing system is opaque and the clearinghouse doesn’t know who actually owns the risk in the majority of positions,” says George Bollenbacher, head of fixed income research at Tabb Group. “The other issue is that there are only relatively few clearing members and most of the participants use futures commission merchants (FCMs), who are careful not to reveal who their customers are. There has been a lot of discussion about waterfall processes, compression and reducing exposures, but there are still a lot of linkages which can potentially create significant problems.”

“One of the problems is the clearing system is opaque and the clearinghouse doesn’t know who actually owns the risk in the majority of positions. The other issue is that there are only relatively few clearing members and most of the participants use futures commission merchants (FCMs), who are careful not to reveal who their customers are. There has been a lot of discussion about waterfall processes, compression and reducing exposures, but there are still a lot of linkages which can potentially create significant problems,” says George Bollenbacher, Tabb Group.

Bollenbacher also points to the pitfall of the shrinking pool of FCMs, which have been under pressure from low interest rates and as a result have had to turn their attention to their larger, wealthier customers. “The view is that the smaller clients are not worth their while, and the result is a drought of clearing services for smaller firms,” he adds. “The result is that some CCPs are offering services that will enable them to clear directly.”

There are just 63 FCMs registered with the CFTC, according to Tabb Group’s 2017 US Futures Market review released in February 2018—almost half the number fifteen years ago. The top ten accounted for 73.2% of total assets at the end of December 2017, with Goldman Sachs in pole position with a roughly 14% share as measured by customer account balances. JP Morgan was the runner up with 11.4%, while Bank of America Merrill Lynch and Morgan Stanley both remained ahead of Société Générale, followed by Citi Group and UBS who tied for sixth place. Bringing up the back was Wells Fargo and Royal Bank of Canada who continued to slowly gain market share

Although the dwindling number of FCMs is changing market dynamics, Alex McDonald, CEO of European Venues and Intermediaries Association (EVIA), believes there are other factors, such as equivalence and the dispersion of liquidity, to take into consideration. “The largest CCPs have a preponderance of the same clearing members, plus banks are safer today than they were ten years ago because of the decade of remedial measures, and in particular due to stress testing and better reporting which has increased transparency,” he adds.

He notes the recent speech by Hyun Song Shin, Economic Adviser and Head of Research of the BIS and adds, “The system has made good progress in moving risk off balance sheets, although there are still problems caused by early attempts at regulatory repair, resulting in the fragmentation of liquidity on different platforms and the lack of deference between different jurisdictions. However, these are problems that have to be solved politically, and CFTC Chairman Christopher Giancarlo’s recent speeches in the City, Vienna and in Singapore are looking to address some of these issues via an imminent policy white paper.”

Are custodial banks becoming too systemically important?

Other industry observers believe there are dangers lurking in parts of the financial services ecosystem that are being neglected. “The concept of CCPs being too big to fail depends on how you look at risk,” says Russell Dinnage, Head of the Capital Markets Intelligence Practice at GreySpark Partners, adding that the regulatory push towards central clearing has in fact “sanitised” the risks and shared them among the clearing banks.

“The participants that I worry most about are the custodial banks, whose assets under custody have continued to grow as investors have moved into passive investments such as ETFs (exchange traded funds),” he adds. “They have become increasingly important and play an immensely significant role in managing, for example, cash flow from repo and structured products.”

At the end of the second quarter, the four largest banks continued to dwarf the other players, according to a study cited in Trefis, published by Forbes. Together, they amassed $114 trillion assets under custody and administration, with BNY Mellon retaining its crown with $33.6 trillion, followed by State Street at $32.9 trillion, JP Morgan at $26.3 trillion and Citi at $19.4 trillion.

Looking ahead, it is difficult to predict what will happen in the next ten years, but JP Morgan is predicting the next recession may be just around the corner. A new model the bank has built puts the odds of a recession starting in 2019 at 25%, as monetary policy and quantitative easing introduced to keep the economy afloat begins to reverse. However, somewhat reassuringly, the firm’s CEO Jamie Dimon recently told reporters that the banking system was “very, very healthy” and that a collapse like Lehman’s would not happen today. Whether he proves right or not, hopefully the industry will have learned the right lessons before the next crisis does inevitably hit.